We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
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Wednesday, October 15, 2008

With the credit crisis accelerating and governments attempting a number of "solutions," investors are being introduced to a wide variety of credit metrics. Here is a quick list of the credit market indicators that really matter, and where you can find up-to-date data on each.

LIBORLIBOR has gotten plenty of press, but many have been focused on the TED spread, which is the yield differential between 90-day T-Bills and 90-Day LIBOR. TED is interesting in terms of historic comparison, but its the absolute level of LIBOR that is a better credit indicator right now. With T-Bill rates extremely low (0.19% as of 10/10), and intra-day T-Bill moves highly volatile, it would be entirely possible to see T-Bill rates rise by some degree without any significant improvement in conditions. Thus the TED spread would technically be tighter, but to no import.

Instead, watch 1-month and 3-month LIBOR rates. Both should be around 1.5-2%, based on where the Fed Funds target is. Watch Euro-denominated rates as well. A governmental guarantee of inter-bank loans would certainly drive LIBOR lower, as LIBOR is supposed to measure inter-bank lending rates. Otherwise I'd expect LIBOR to remain elevated until at least year-end.

Commercial Paper Term SpreadMany have been watching commercial paper outstanding as a credit market indicator. The problem there is that CP issuance is bound to decline as the system delevers, so total CP outstanding may see year-over-year declines, even as credit conditions are improving. A much better indicator is the yield spread between over-night CP and 60-day CP. Currently over night AA-Finance CP costs firms 1.23%, according to the Federal Reserve, whereas 60-day CP costs 3.51%. Under normal conditions, those rates would be within 25bps of each other.

The Fed also reports on asset-backed CP rates in the same report. These should converge with AA-Finance rates as conditions improve.

Municipal Bond Swap IndexThis index measures the average reset rate on tax-exempt, weekly Variable Rate Demand Notes (VRDN) issued by municipalities. Basically, it is the cost of short-term funding for municipal issuers. It is calculated by the Securities Industry and Financial Markets Association (SIFMA) and hence is often just called the SIFMA index.

VRDN's are a mainstay of municipal money-market funds. Investors in a VRDN can put their bond back to the issuer at any reset date, which in this case is weekly. This liquidity is usually guaranteed by a highly-rated bank. With banks under such pressure recently (Wachovia and Dexia were major players in this business), and with municipal money-market funds seeing massive redemptions, VRDN rates have risen dramatically.

Typically the SIFMA rate is between 60 and 80% of the 1-week LIBOR rate. So if LIBOR were 4%, SIFMA would usually come in around 3%. But the SIFMA rate spiked to 7.96% on September 24, and although it has fallen to 4.82% as of last week, the level is far above normal levels.

If there rates remain elevated, municipalities will be under pressure to refinance their variable rate debt with long-term debt. And any kind of debt issuance is extremely expensive in this market. However, falling SIFMA rates would indicate investor confidence in municipal issuers.

SIFMA updates its index each Wednesday. Note that VRDNs are not the same as Auction Rate Securities, which remain highly illiquid.

CMBXThe CMBX is a basket of credit default swaps on commercial mortgage-backed securities (CMBS). It goes without saying that commercial mortgages are likely to suffer significant losses in the near future, likely larger than other recent recessions. At the same time, commercial mortgage securities are structured with significant levels of subordination. This means that junior securities take losses before more senior securities suffer. A typical CMBS deal would have 30% or so subordination beneath the AAA-rated tranche.

So while losses may be high, not too many deals will suffer much more than 30% in losses (which implies a much greater default rate). In addition, principal payments go to retire higher-rated tranches first, therefore the subordination actually increases over time. Thus the spread on AAA-rated CMBS should remain relatively tight. Right now, the recent vintage AAA CMBX is trading in the 220bps area.

There are a few other indicators which are commonly cited but I don't think are very useful. One is swap spreads. This is the spread between the fixed-leg of a fixed-to-floating swap and a corresponding Treasury. Classically this was seen as a generalized measure of counter-party risk, since normally a highly-rated bank would stand in the middle of any interest rate swap. However right now the swaps market is being driven by some unusual technicals. Note that the 2-year swap spread is at all-time wides, where as the 10-year swap spread is only a couple basis points wider than its 10-year average. The 30-year swap spread is at all-time tight levels. So as a day-to-day indicator, swap spreads aren't very informative.

Another is Agency debt spreads. With Fannie Mae and Freddie Mac now fully backed by the Treasury, one would expect those spreads to collapse to near zero. Yet currently 2-5 year Agency debt is trading at 100bps or more above comparably Treasury rates. While this is indicative of how bad liquidity currently is in the market, this is as much a function of swap spreads as anything else. As long as swap levels remain elevated, so will Agency debt spreads.

Finally, the various measures of borrowing at the Fed. This includes the discount window, the TAF, the TSLF, etc. Investors should realize that the mere existence of these facilities has an influence over how much institutions use them. Put another way, the fact that we need these programs is the real indicator. The most recent TAF auction on 10/6 produced the lowest stop-out rate since the program's inception. Yet I have a very hard time saying liquidity is improving.

Big Question for you Accrued... if the banks all got capital injections that require a 5% dividend return, why does anyone expect LIBOR (currently at 4.75%) to fall? The banks have to make 5.01% on the money, just to be able to return it to the government. Why isn't this troubling for anyone else? Why didn't we just take common stock if the crisis was that serious? Who the freak is running our banking system? Are Neel Kashkari and Paulson really this stupid?

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.